Solving for Fixed Income

Since 2004, J.P. Morgan has produced “Market Insights” to help individual investors understand and make their way through rapidly shifting markets.

Today, even with yields rising from historic lows, we believe fixed income has a vital role to play in diversifying portfolio returns, helping to preserve portfolio value against volatility and providing a reliable source of income. “Solving for Fixed Income” takes a look at how the current environment has affected fixed income’s traditional role and at the many other opportunities that can accomplish its traditional objectives.

1. LOW RETURNS FROM CASH

Cash can be a real drag

In the short term, having a little extra cash can be beneficial if you need to allocate quickly to new opportunities. However, cash is definitely no longer the king with respect to long-term investment returns.

Even as central banks embark on a new rate hiking cycle, there is debate about just how high interest rates can go, and whether they will beat inflation.

Despite yields on government bonds still being very low, fixed income continues to play an essential role in diversifying investment portfolios.

2. THE IMPORTANCE OF INCOME

Maximize investment growth with bonds

The total return on fixed income investments consists of two components: price, or capital, appreciation and coupon return.

The steady stream of income earned from the coupon can increase the total return from fixed income and act to partially offset any capital loss should it occur. This serves as a critical buffer for portfolios, especially in an environment of rising yields.

When thinking of returns from fixed income, investors should focus on the total return, and the importance of that flow of income, in adding to that return.

3. MOVING BEYOND GOVERNMENT BONDS

Searching for higher yields

Central banks desire to avoid deflation have seen them adopt increasing accommodative policies over the years, penalizing those seeking income from government bonds.

Yields are set to rise as these policies start to be unwound, and government bond holders now face capital losses.

Income seekers have options across the credit spectrum. Moving beyond government bonds in search of higher yields in credit and emerging market debt.

These bonds may have lower duration meaning they are less sensitive to rising interest rates.

4. GLOBAL INVESTMENT-GRADE BONDS

The safety of investment-grade bonds

Investment-grade bonds are corporate bonds associated with companies with a relatively low chance of defaulting their obligations. The default risk is reflected through a higher yield as compared to what is offered by a government bond, and the yield difference is known as the spread. This spread presents another source of income and a return that will beat cash in the current environment.

A selective approach to investment grade bonds can add to the consistency of returns in a fixed income portfolio as economies continue to recover, earnings growth stabilizes and credit fundamentals of the overall corporate bond market improve.

Investors should be aware that the duration of some investment grade bond benchmarks has risen in recent years.

5. HIGH YIELD BONDS

Taking advantage of higher yields

High yield bonds have a rating below investment grade and offer more yield to compensate for the additional credit risk. These bonds continue to help investors achieve higher yield amidst the current low yield environment.

The spread on the yield of high yield bonds over government bonds has narrowed in recent years, meaning a lower level of income. However, this reflects the falling credit risk as the default rate for the high yield market is below 1%.

High yield bonds have a higher correlation to equities than investment grade or government bonds. Investors should be mindful of increasing equity like risk in their portfolio when adding high yield debt.

6. DIVERSIFICATION AND FLEXIBILITY

Why diversification works

Fixed income investments diversify portfolios because they generally exhibit low correlation to other asset classes.

This principle applies within an asset class as well as across them. Investors should consider how to diversify within the fixed income market.

In the last decade, a portfolio that included a wider array of fixed income assets has outperformed Australian government bonds.

Investors should also consider how they allocate to each fixed income market segment as the drivers of return, sensitivity to interest rates and corporate fundamentals will affect returns.

Given the uncertain growth, rate and inflation outlook, the ability to allocate across the bond market may be advantageous.

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